The Downside of Loans

The Tendency to Overspend

Overspending is a risk that everyone potentially faces, and this is something that all of us have to actively look to prevent whether or not we are using borrowed funds or our own money.

For example, we may have some money set aside for a specific purpose, saving for something in particular or to have as a contingency fund, and the risk is that we will spend the money on something less important and not have the money available to buy what we want or to have in case we need the funds for something more important.

The Downside of LoansWhen we use our own money though, our overspending is limited to the funds we have. Still though, it is important to save money, and we can undo carefully thought out and executed plans if we do not have the proper discipline to follow through with our plans consistently.

This is really the key to successful personal financial management, to act with the right amount of discipline, which doesn’t really mean acting as frugally as possible, although in some cases it might, if that is required.

We don’t necessarily want to always live on a shoestring budget, like Mr. Scrooge turning down an extra potato because it costs half a penny more when he really wanted it, and has the means to easily afford it. The idea of accumulating wealth is to enjoy it, and you want to strike a balance between enjoying it now and providing for your future, and also ensuring that any and all spending fits your overall objectives and leads to the most overall satisfaction for you.

Perhaps achieving this maximum satisfaction is going to involve spending very little and saving almost everything, or maybe it’s going to involve spending most of it and saving less. We want to first make sure that our plan makes sense from an objective perspective though, especially as far as its sustainability, and this is where overspending fails.

Over Borrowing Can Really Fuel Overspending

When we’re looking to borrow, the first decision is whether borrowing makes sense for us according to our current circumstances as well as our future expectations. It may be that waiting to make the purchase that the borrowing is directed at obtaining now may be the better choice, and we want to avoid being too impulsive and impetuous.

The desire to have something now versus later can be a pretty strong one, where one buys more on emotions than based upon objective decision making. Buying on emotions is not a bad thing, especially since satisfaction of some sort is the end objective of personal financial management. The goal is to get happy and look to seek to maximize that, and being happy is an emotion, so emotions aren’t all bad to be sure.

When we act upon emotion to the extent that we are acting without due regard to the objective conditions of the deal, this is where we can get ourselves into trouble. So, while emotions should be taken into account, we also need to do some deliberation as to our capacity to fulfill our emotions by spending money as well as the opportunity costs of doing so, comparing the strategy to other options.

This is the part that many people don’t properly account for, and there’s always an opportunity cost involved, comparing the plusses and minuses of the purchase versus the plusses and minuses of doing something else with the money, and where borrowing is concerned, this includes doing nothing at all.

Even borrowing though has its opportunity cost, as if you borrow now, you are reducing your capacity to borrow, and something else may arise later where you may want to borrow for but can no longer do so.

So, overborrowing doesn’t just involve borrowing beyond our capacity to repay the debt, or placing ourselves at risk of changing circumstances resulting in a loss of this capacity, it’s also a relative thing, relative to what else we may do with the money.

In this case, we’re talking about not necessarily borrowing too much money, but instead using up our borrowing capacity on the wrong things, which may be either the wrong things now or the wrong things that may prevent us from buying the right things later.

Making Sure We Can Service our Debts

While lenders do take the capacity to repay debts into account, as best they can, there’s no way that they can fully protect us from becoming overextended right now, because they only look at certain components of spending.

In calculating one’s debt ratios, lenders will look at things like minimum payments that must be made on existing debts, plus housing costs. There is a lot of spending that these ratios don’t cover, things that can be quite variable. For instance, child care costs aren’t accounted for generally.

People spend variable amounts on things besides debt servicing and housing costs, and the ratios that lenders use do offer plenty of opportunity for anyone to have themselves in a very uncomfortable situation, or even be set up to fail.

While one may be able to reduce one’s spending to better balance their budgets, even cutting down a lot may not be enough if one is exposed to too high debt servicing payments. This is especially a risk given how loose credit card companies are at expanding people’s credit limits, often with very little or no regard to one’s debt ratios or whether they put people in a position to fail.

Credit cards charge higher interest rates though so they can afford to manage a higher default rate, and therefore they rely much more on one’s credit rating and history with repaying the credit card account than one’s capacity to pay.

This leaves many people at serious risk of overextending themselves should they choose, because it gives them the weapons to do so. As one’s borrowing increases, the escalating interest costs alone can set one on a path of destruction, where more and more borrowing is needed just to pay the interest on one’s debt, eventually leading to the point where one reaches the point where no further borrowing is possible, and default becomes unavoidable.

While default is the extreme outcome of overborrowing, its hardship isn’t limited to that, as it can cause various degrees of financial hardship even when the debt can continue to be serviced. If the payments continue to be made, if these payments are too high of a proportion of one’s income, this may prevent people from being able to afford things that are more important to them than what was obtained from the borrowing, which may include some very important things.

Accounting for Changing Circumstances

Being comfortable with a certain level of borrowing at the present time does not mean that you will continue to be during the life of the loans that you currently have out. Payments have to be maintained generally regardless of any changes in your circumstances, and while there is some flexibility here, refinancing your current debt for instance, we do need to be well aware that our financial circumstances may change for the worse and be prepared for that.

This is one of the biggest concerns with taking on a lot of debt, and while one may undergo big life events that may lead to bankruptcy, job loss or relationship breakdowns or the like, and some of these risks may be worth taking, we really want to look to minimize the risk of such things happening to us.

Creditor insurance can protect you against such things as losing your job or becoming disabled, but there are some things that can arise that you can’t insure against that may present various levels of difficulty in maintaining your debt obligations.

It therefore can be fairly important to look to assess the risks of significant events impacting your ability to repay your current debts. Perhaps you are in a shaky relationship or don’t have a lot of job stability, or there may be a big expense coming up that is going to make a real difference in your ability to service your obligations.

This should all be accounted for in the decision to borrow and if things don’t look all that secure during the life of the loans you are considering taking out, this should at least give you pause for thought and if there’s an opportunity to forestall or avoid the borrowing, that should be considered in these circumstances.

Just as one should be calculating expected increases in income when looking to decide on one’s future borrowing capacity, we also need to account for expected reductions in income. If one is looking to retire soon for instance, we need to prepare ourselves for these events and reduce our debt load accordingly.

While this may seem to be obvious, there are a lot of people who retire with quite a bit of debt, and others who may wish to retire but they cannot due to their not being able to afford to, and debt obligations can impede this transition.

It is important to budget properly and one of the biggest reasons people fail at borrowing is that they don’t properly budget, and enter into loans with less regard to their capacity and especially what they may have to give up to take on the new loans.

In the end, any time we borrow, we need to carefully consider all of the factors involved, to decide how much we can comfortably borrow now and how much debt we can comfortably take on down the road as well.

John Miller


John’s sensible advice on all matters related to personal finance will have you examining your own life and tweaking it to achieve your financial goals better.

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